Five hidden risks ETF investors should watch out for

Exchange traded funds (ETFs) can be fantastic – they can offer investors exposure to their chosen asset class in a way that is low cost, simple and efficient. For example, if you want access to the American market, broadly defined as the S&P 500 Index, there are several products out there that will give you tracking exposure to that market. Being purely ‘passive’ investments, they will do so cheaply and simply. In this instance, they also do it reasonably efficiently, insofar as an ETF can be expected to perform more or less the same way as the underlying index it tracks.

So, what’s not to like? As the market continues to expand rapidly, I am going to highlight five risks that all ETF investors need to be aware of. 

Market Risk

ETFs are designed to follow an index, a basket of securities, an asset, or even a derivatives contract. Ultimately, they are designed to just follow an underlying reference asset - passive tracking means you enjoy the upside when that asset rises and take the hit when it falls.

The problem is that an ETF cannot modify its approach during a downturn in the market. As such, the investor has no choice about following the performance of whatever it is the ETF is designed to track, whether that performance is good or bad.

The tyranny of choice

As the market has expanded, so has the range of products available. There are around 2,000 listed ETFs in the US alone, a huge increase over the past 5 years or so. Some sound very similar, but performance can vary. How do you shop for the right one?

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Suppose you are interested in a biotech ETF. You face some challenges when choosing, as ETF products can vary depending on the provider - the underlying basket of securities being tracked will not be the same in all cases and therefore performance and cost can vary too. These differences need to be scrutinised just as thoroughly as with any other investment.

Meanwhile, the recent growth in the market has spawned many esoteric, even bizarre, ETFs. Some of these are expensive and their performance can be hard to predict. In a few cases their very survival is far from guaranteed if they prove to be a flop post-launch. 

Complications

ETF are supposed to be simple, efficient and low cost, but some are really not any of those things. For example, you can get an ETF that offers twice the inverse performance of an underlying index. Even if you can understand how it works, you still need to watch out, as the performance that these generate, (thanks to a feature called ‘daily repricing’) may not be exactly what you expect.

Meanwhile, if you are buying an oil ETF, for example, you need to know what it is tracking – the physical market, an index or a derivative contract. The oil market is complex and so are some of the products designed to track it. 

Poor liquidity

This is a particular problem in certain parts of the market. For example, if you are considering an ETF which tracks high yield bonds, you should be aware that underlying bonds can be relatively illiquid. This can create a problem if there is a stampede for the exit should investors start to panic in a downturn and dump those bonds. In a very worst-case scenario, a specialist ETF provider could go out of business. At the very least, the ETF could suffer a much sharper price fall than you expect. 

Behavioural risk

The very fact that many ETFs can be bought easily, simply and cheaply means that investors may be tempted to overtrade them. People who would otherwise be sensible, long-term investors begin trying to time the markets over the short-term. In doing so, they risk destroying the original low-cost objective of using ETFs by taking trading-style risks and paying too much in commission.    

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